Insurance: The Archetypal Risk Management Institution – Yale, Econ 252, 5.1
Posted on | February 9, 2009 | No Comments
This is synopsis one of two from lecture five of Dr. Shiller’s Yale ECON 252 course: Financial Markets. Go to the ECON 252 link to access all synopses to this point.
Since 1802 stocks have outperformed bonds by an average of 4% per year. There has never been a 30 year period in the history of the United States, since 1802, in which bonds outperformed stocks as a whole. Jeremy Seigel did the research back to 1802 and stated his evidence in his book Stocks For the Long Run. The problem with this data set is that it is comparing stocks from the most successful country in the world. When more in depth research was done, it actually showed that Sweden and Australia actually had more successful stock markets than the United States. This dispels the idea of selection bias in Jeremy Seigel’s data. Russia and China are not included in the data as they had Communist uprisings during that period.
There are two types of tax that are paid from profits on stocks; corporate tax and personal income tax. Corporate tax is paid by the corporation and is currently 33% of their profits. Do not be fooled into thinking that this is how much they pay as there are many loopholes to get out of some of these taxes. Personal income tax is paid by shareholders on their dividends. During World War II, tax on dividends was actually 90%! Today it is a more reasonable 15%.
Insurance is a risk management practice of risk pooling. The idea is to pool as many independent variables as possible to lower the correlation of risk. Two factors that have to be considered when pooling risk is moral hazard and selection bias. It is the case that when insurance is offered, it is the individuals who are at higher risk who want the insurance. The binomial distribution is the probability of an accident happening as shown below:
The larger that n gets, the skinnier and higher the graph looks. Ultimately, insurance companies want to have as many policy holders as possible to lower their risk of one large accident causing them to go bankrupt.
There are two types of insurance: multi line and mono line. Multi line insurance companies offer many different types of insurance while mono line companies only offer one type. A mono line insurance company is much more risky and has been hit extremely hard by the subprime crisis.
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